Chapter 5: Time Value Of Money PDF

CHAPTER 5 TIME VALUE OF MONEY Chapter Outline - Cost-Benefit Analysis - Market Prices and the Valuation Principle - The Time Value of Money and Interest Rates - Valuing Cash Flows at Different Points in Time Learning Objectives  Identify the role of financial managers and competitive market...

CHAPTER 5 TIME VALUE OF MONEY Chapter Outline - Cost-Benefit Analysis - Market Prices and the Valuation Principle - The Time Value of Money and Interest Rates - Valuing Cash Flows at Different Points in Time Learning Objectives  Identify the role of financial managers and competitive markets in decision making  Understand the Valuation Principle, and how it can be used to identify decisions that increase the value of the firm  Assess the effect of interest rates on today’s value of future cash flows  Calculate the value of distant cash flows in the present and of current cash flows in the future 1- Cost-Benefit Analysis  Role of the Financial Manager  Make decisions on behalf of the firm’s investors ◼ For good decisions, the benefits exceed the costs 1- Cost-Benefit Analysis  Role of the Financial Manager  Real-world opportunities are often difficult to quantify and involve using skills from other management disciplines: ◼ Marketing ◼ Economics ◼ Organizational Behavior ◼ Strategy ◼ Operations 1- Cost-Benefit Analysis  Quantifying Costs and Benefits  Any decision in which the value of the benefits exceeds the costs will increase the value of the firm  1- Cost-Benefit Analysis  Quantifying Costs and Benefits  Role of Competitive Markets ◼A competitive market is one in which a good can be bought and sold at the same price ◼ In a competitive market, the price determines the value of the good ◼ Personal opinion of the “fair” price is irrelevant Evaluate:  As we emphasized earlier, whether this opportunity is attractive depends on its net value using market prices.  2- Market Prices and the Valuation Principle  The Valuation Principle  The value of a commodity or an asset to the firm or its investors is determined by its competitive market price  The benefits and costs of a decision should be evaluated using those market prices  When the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm Evaluate:  Since we are transacting today, only the current prices in a competitive market matter  Our own use for or opinion about the future prospects of oil or copper do not alter the value of the decision today  Since we are transacting today, only the current prices in a competitive market matter 2- Market Prices and the Valuation Principle  Why There Can Be Only One Competitive Price for a Good  Law of One Price ◼ Incompetitive markets, securities with the same cash flows must have the same price 2- Market Prices and the Valuation Principle  Why There Can Be Only One Competitive Price for a Good  Arbitrage ◼ Themethod on the stock exchange of buying something in one place and selling it in another place at the same time, in order to make a profit from the difference in price in the two places  Arbitrage Opportunity ◼ Any situation in which it is possible to make a profit without taking any risk or making any investment 3- The Time Value of Money and Interest Rates  The Time Value of Money  In general, a dollar today is worth more than a dollar in one year ◼ If you have $1 today and you can deposit it in a bank at 10%, you will have $1.10 at the end of one year  The time value of money is the difference in value between money today and money in the future. 3- The Time Value of Money and Interest Rates  The Interest Rate: Converting Cash Across Time  By depositing money, we convert money today into money in the future  By borrowing money, we exchange money today for money in the future